Friday, March 24, 2017

Tactical Short Video Part III: Our Investment Process

The Latest: Video III

More on My New MWM Endeavor and Videos

Weekly Commentary: Discussions on the Fed Put

Market focus this week turned to troubled healthcare legislation, with the GOP Friday pulling the vote on the repeal of Obamacare. This “Republican Catastrophe” (Drudge ran with a Hindenburg photo) provided a timely reminder that Grand Old Party control over the presidency and both houses of congress doesn’t make it any easier to come to a consensus for governing a deeply-divided country. The reality is that it’s a highly fractious world, nation, Washington and Republican party – and the election made it only more so. Perhaps Monday’s sell-off was an indication that reality has begun to seep back into the marketplace. If repealing Obamacare is tough, just wait for tax reform and the debt limit.

CNBC’s Joe Kernen (March 20, 2017): “For a guy that was there trying to deal with the housing Bubble - that would be the other thing that people would bring up to you. That you don’t know what low rates are really doing. You don’t know where the next dislocation is going to be. You’re not seeing a lot of benefits from zero, and who knows if you might be inflating something somewhere that comes home to roost in the future. That’s probably what they’d say: ‘You must know there’s nothing on the horizon then.’”

Neel Kashkari, Minneapolis Federal Reserve Bank president: “It’s a very fair question and people point to the stock market’s been booming. And my response to those folks is, we care about asset price movements if we think a correction could lead to financial instability or financial crisis. If you think about the tech Bubble - the tech Bubble burst. It was not good for the economy – obviously it hurt. But there was no risk of a financial collapse, not like the housing Bubble. So, the difference is the housing market has so much debt underneath it. It’s much more dangerous if there’s a correction. If equity markets drop, it’s going to be painful for investors. But there’s so little debt relative to housing, it doesn’t look like it has a risk of leading to any kind of financial crisis. So, our job is to let the markets adjust.”

Less than an hour later Kashkari appeared on Bloomberg Television: “Some people have said we should be raising rates because markets are getting hot – and the stock market keeps climbing. I think we should only pay attention to markets if we believe it could lead to financial instability. So, go back to the tech Bubble, when tech burst it was painful for the economy; it was painful for investors. But it did not lead to any kind of economic collapse or financial instability. So, if stock markets fall it’ll hurt investors. But that’s not the Fed’s job. The Fed’s job is not to protect stock market investors. We have to pay attention to potential financial instability risks, and the fact is there’s a lot more debt underlying the housing market than underlying the stock market. That’s why the housing bust was painful for the economy. A stock market correction will probably be a lot less painful.”

Neel Kashkari these days provides interesting subject matter. It’s no coincidence that he’s been discussing shrinking the Fed’s balance sheet while also addressing the “Fed put” in the stock market. I’m sure Kashkari and the FOMC would prefer that market participants were less cocksure that the Fed stands ready to backstop the markets. Too late for that.

Fed officials are not blind. They monitor stock prices and corporate debt issuance; they see residential and commercial real estate market values. Years of ultra-low rates have inflated Bubbles throughout commercial real estate – anything providing a yield – in excess of those going into 2008. Upper-end residential prices are significantly stretched across the country, also surpassing 2007. They see Silicon Valley and a Tech Bubble 2.0, with myriad excesses that in many respects put 1999 to shame. I’ll assume that the Fed is concerned with the amount of leverage and excess that has accumulated in bond and Credit markets over the past eight years of extreme monetary stimulus.

The Fed is locked into a gradualist approach when it comes to normalizing rate policy. At the same time, they must of late recognize that speculative markets might readily brush aside Fed “tightening” measures. This might help to explain why the Fed’s balance sheet is suddenly in play. And it’s not just Kashkari. From Bloomberg: “Fed’s Kaplan Says MBS and Treasuries Should Both Be Rolled Off” and “Bullard Says Fed in Good Position to Allow Balance Sheet to Fall.” From Reuters: “Cleveland Fed President Says She Supports Reducing the Balance Sheet.” From Barron’s: “Fed's Williams: Balance Sheet Shrinkage Could Begin Late this Year.” And my favorite: “Fed’s Kashkari: Everyone on FOMC ‘Very Interested’ in Balance Sheet Policy.”

I struggle taking comments from Fed officials at face value. Kashkari shares a similar revisionist view of the Tech Bubble experience to that of Ben Bernanke, Alan Greenspan and others: Basically, it was no big deal – implying that Bubbles generally don’t have to be big deals. They somehow banished 2002 from their memories.

The Fed collapsed fed funds from 6.50% in December 2000 to an extraordinarily low 1.75% by the end of 2001. In the face of an escalating corporate debt crisis, the Fed took the unusual step of cutting rates another 50 bps in November 2002. Alarmingly, corporate Credit was failing to respond to traditional monetary policy measures (despite being aggressively applied). Ford in particular faced severe funding issues, though the entire corporate debt market was confronting liquidity issues. Recall that the S&P500 dropped 23.4% in 2002. The small caps lost 21.6%. The Nasdaq 100 (NDX) sank 37.6%, falling to 795 (having collapsed from a March 2000 high of 4,816). No financial instability?

Years later it’s easy to downplay consequences of the bursting “tech” Bubble. Yet there were fears of a deflationary spiral and the Fed running out of ammo. It was this backdrop in which Dr. Bernanke introduced unconventional measures in two historic speeches, the November 21, 2002, “Deflation: Making Sure ‘It’ Doesn’t Happen Here” and the November 8, 2002, “On Milton Friedman’s Ninetieth Birthday.”

I revisit history in an attempt at distinguishing reality from misperceptions. Of course the Fed will generally dismiss the consequences of Bubbles. They’re not going to aggressively embark on reflationary policies while espousing the dangers of asset price and speculative Bubbles. Instead, they have painted the “housing Bubble” as some egregious debt mountain aberration. And paraphrasing Kashkari, since today’s stock market has nowhere as much debt as housing had in 2007, there’s little to worry about from a crisis and financial instability perspective.

Well, if only that were the case. Debt is a critical issue, and there’s a whole lot more of it than back in 2008. Yet when it comes to fragility and financial crises, market misperceptions and distortions play fundamental roles. And there’s a reason why each bursting Bubble and resulting policy-induced reflation ensures a more precarious Bubble: Not only does the amount of debt continue to inflate, each increasingly intrusive policy response elicits a greater distorting impact on market perceptions.

I doubt Fed governor Bernanke actually anticipated that the Fed would have to resort to “helicopter money” and the “government printing press” when he introduced such extreme measures in his 2002 speeches. Yet seeing that the Fed was willing to push its monetary experiment in such a radical direction played a momentous role in reversing the 2002 corporate debt crisis, in the process stoking the fledgling mortgage finance Bubble. And the Bernanke Fed surely thought at the time that doubling its balance sheet during the 2008/09 crisis was a one-time response to a once-in-a-lifetime financial dislocation. I’ll assume they were sincere with their 2011 “exit strategy,” yet only a few short years later they’d again double the size of their holdings.

From a friendly email received over the weekend: “I think the Bernanke doctrine ended up being wildly successful beyond anyone’s imaginings, even Dr. Ben’s.” This insightful reader’s comment is reflective of the positive view markets these days (at record highs) hold of “activist” central bank management. It may have taken a while, but it all eventually gained the appearance of a miraculous undertaking – reminiscent of “New Era” hype from the late-nineties. “Money” printing works – and all the agonizing over unintended consequences proved sorely misguided!

So easy to forget how we got here. We’re a few months from the nine-year anniversary of the 2008 crisis, yet there’s still huge ongoing global QE and rates not far from zero. It’s a monetary inflation beyond anyone’s imaginings, even Dr. Ben’s. To say “the jury’s still out” is a gross understatement.

There’s a counter argument that stimulus measures and monetary inflation got completely away from Dr. Bernanke - and global central banks more generally. Today, peak global monetary stimulus equates with peak securities market values and peak optimism – all having been powerfully self-reinforcing (“reflexivity”). Global debt continues to expand rapidly, led by exceedingly risky late-cycle Credit growth out of China. I suspect that unprecedented amounts of speculative leverage have accumulated globally, led by excesses in cross-currency “carry trades” and derivatives. “Money” continues to flood into global risk markets, inflating prices and expectations. Worse yet, excesses over (going on) nine years have seen an unprecedented expansion of perceived money-like government and central bank Credit (the heart of contemporary “money” and Credit). Meanwhile, global rates have barely budged from zero.

Despite assertions to the contrary, the bursting of the “tech” Bubble unleashed significant financial instability. To orchestrate reflation, the Fed marshaled a major rate collapse, which worked to stoke already robust mortgage Credit growth. The collapse in telecom debt, an unwind of market-based speculative leverage and the rapid slowdown in corporate borrowings was over time more than offset by a rapid expansion in housing debt and enormous growth in mortgage-related speculative leverage (MBS, ABS, derivatives).

Understandably, Kashkari and the Fed would prefer today to ween markets off the notion of a “Fed put.” It’s just not going to resonate. Markets will not buy into the comparison of the current backdrop to the “tech” Bubble period. The notion that today’s securities markets operate without major instability risk is at odds with reality.

Markets are keenly aware that the Fed’s balance sheet will be the Federal Reserve’s only viable tool come the next period of serious de-risking/de-leveraging. At the same time, Fed officials clearly want to counter the now deeply-embedded perception of a “Fed put” – that the Federal Reserve remains eager to counter fledgling “Risk Off” dynamics. And while it’s not surprising that markets hear Kashkari’s comments and yawn, things will turn interesting during the next bout of market turbulence. Expect the Fed to move hesitantly when coming to the markets’ defense, a dynamic that significantly raises the potential for the next “Risk Off” to attain problematic momentum. It’s been awhile.

March 20 – Financial Times (Robin Wigglesworth): “On Wall Street, bad ideas rarely die. They often go into hibernation until resurrected in a new form. And portfolio insurance — a leading contributor to the 1987 ‘Black Monday’ crash — is, for some, making a return to markets. Institutional investors are allocating billions of dollars to ‘risk mitigation’ or ‘crisis risk offset’ programmes that are designed to act as a counterweight when markets are in turmoil. They mostly comprise long-maturity government bonds and trend-following hedge funds, which tend to do well when equities plummet. But some analysts and fund managers worry that if taken to extremes, allocations to trend-following ‘commodity trading advisors’ hedge funds, in particular, could play the same role as an investment concept called portfolio insurance did in 1987, when it was blamed for aggravating the worst US stock market collapse in history. ‘There’s a big portfolio insurance industry that no one is talking about . . . CTAs are dangerously close to portfolio insurance,’ argues Robert Hillman, the head of Neuron Advisors…”

Writing flood insurance during a drought is an alluringly profitable endeavor. The “Fed put” has encouraged Trillions to flow into the risk markets. Trillions of “money” have gravitated to “passive” trend-following securities market products and structures. Yet the most dangerous Fed-induced market distortions may lurk within market hedging strategies. The above Financial Times article ran under the headline “Rise in New Form of ‘Portfolio Insurance’ Sparks Fears.” Fear is appropriate. To what degree has it become commonplace to seek profits “writing” various types of market “insurance” in a yield-hungry world confident in the central bank “put.” How much “dynamic hedging” and derivative-related selling waits to overwhelm the markets in the event of a precipitous market sell-off (concurrent with fear the Fed has stepped back from its market backstopping operations)?

The speculative bull market confronted some Washington reality this week. The S&P500 declined 1.4%, the worst showing in months. The banks (BKX) were slammed 4.7%, with the broker/dealers (XBD) down 4.3%. The broader market was under pressure, with the mid-caps down 2.1% and the small caps 2.7%. It’s worth noting the banks, transports and small caps are now all down y-t-d. Curiously, bank stocks underperformed globally. Japan’s Topic Bank index was hit 3.5%. The Hong Kong Financial index fell 1.3%, and Europe’s STOXX 600 Bank index lost 0.9%.

Ten-year Treasury yields dropped nine bps to a one-month low (2.41%), as sovereign yields declined across the globe. Just when the speculators were comfortably short European periphery bonds, Spanish 10-year yields sank 19 bps, Italian yields fell 13 bps and Portuguese yields dropped 15 bps. Crude prices traded this week to the low since November. The GSCI Commodities Index declined to almost four-month lows. Time again to pay attention to China? This week saw a “super selloff” in Chinese iron ore markets. Copper fell 2.2%, and the commodities currencies (Australia, Canada, Brazil) underperformed. Meanwhile, precious metals outperformed, with gold up 1.2% and silver rising 2.1%.

March 23 – Financial Times (Gabriel Wildau): “China’s financial system suffered a cash crunch this week as new regulations designed to curb shadow banking caused big lenders to hoard funds, highlighting the danger of unintended consequences from official moves to lower their debt. Analysts have warned of rising risks from banks’ increased reliance on volatile short-term funding rather than customer deposits to fund loans and other investments. If money market interest rates spike in times of stress, institutions can be forced to dump assets in order to meet payments due to creditors. Tightening liquidity prompted the seven-day bond repurchase rate to hit a three-year high of 9.5% on Tuesday, versus an average of below 3% since the beginning of 2014.”

March 21 – Bloomberg: “This week’s squeeze in Chinese money markets is proving especially painful for the country’s shadow banks. While interbank borrowing rates have climbed across the board, the surge has been unusually steep for non-bank institutions, including securities companies and investment firms. They’re now paying what amounts to a record premium for short-term funds relative to large Chinese banks… ‘It’s more expensive and difficult for non-bank financial institutions to get funding in the market,’ said Becky Liu, …head of China macro strategy at Standard Chartered Plc. ‘Bigger lenders who have access to regulatory funding are not lending much of the money out.’”

March 23 – Wall Street Journal (Shen Hong): “A new specter is haunting China’s financial system: the negotiable certificate of deposit. An explosion in banks’ use of the bondlike loans, whose durations range from a month to a year, is testing Beijing’s resolve to cure the economy of its addiction to debt-fueled growth and investment booms. As authorities push up key short-term interest rates in their campaign to deflate asset bubbles swelled by borrowed money, the interest rates charged on these NCDs is rising so fast that it is starting to expose banks to the risk of investment losses and abrupt funding squeezes. This is causing worries about a potential repeat of the crippling cash crunch of 2013. ‘NCDs carry a lot of risk, and if not handled properly they could lead to a systemwide liquidity crisis,’ said Liu Dongliang, senior analyst at China Merchants Bank. Banks, mostly small or midsize ones, have been raising record sums via NCDs, selling 4.4 trillion yuan ($639bn) worth this year, 65% more than in the same period of 2016.”

The risk of financial accident in China has anything but dissipated. The People’s Bank of China this week injected large amounts of liquidity to stem a brewing funding crisis in the inter-bank lending market, only then to reverse course back to tightened policy later in the week. Over recent years, each effort to restrain excess in one area has been matched by heightened excess popping out in another. In general, financial conditions have remained too loose for too long – leading to recent Credit growth in the neighborhood of $3.5 TN annualized. Efforts to rely on targeted tightening measures have proved ineffective.

It appears there is now heightened pressure on Chinese monetary authorities to tighten system-wide financial conditions. The stress that befell the vulnerable corporate bond market over recent months is now pressuring small and medium sized banks with problematic exposure to short-term “money-market” borrowings. There were also further indications this week of “shadow banking” vulnerability.

I’ve never felt comfortable that Chinese authorities appreciate the types of risks that have been mounting beneath the surface of their massively expanding Credit system. Global markets seemed attentive a year ago, but concerns have since been swept away by the notion of the all-powerful “China put” conjoining with the steadfast “Fed put.” These types of market perceptions create tremendous inherent fragility.

And thanks for checking out our third of four short videos, Tactical Short Episode III, “Our Investment Process" at

For the Week:

The S&P500 declined 1.4% (up 4.7% y-t-d), and the Dow fell 1.5% (up 4.2%). The Utilities gained 1.3% (up 6.4%). The Banks were slammed 4.7% (down 1.0%), and the Broker/Dealers were whacked 4.3% (up 3.1%). The Transports dropped 2.4% (down 1.3%). The S&P 400 Midcaps fell 2.1% (up 2.0%), and the small cap Russell 2000 sank 2.7% (down 0.2%). The Nasdaq100 dipped 0.8% (up 10.3%), and the Morgan Stanley High Tech index declined 0.8% (up 12.1%). The Semiconductors were unchanged (up 10.8%). The Biotechs fell 1.7% (up 14.1%). With bullion up $14, the HUI gold index jumped 1.9% (up 9.3%).

Three-month Treasury bill rates ended the week at 75 bps. Two-year government yields declined six bps to 1.26% (up 7bps y-t-d). Five-year T-note yields fell seven bps to 1.95% (up 2bps). Ten-year Treasury yields dropped nine bps to 2.41% (down 3bps). Long bond yields fell 10 bps to 3.01% (down 5bps).

Greek 10-year yields were little changed at 7.31% (up 29bps y-t-d). Ten-year Portuguese yields dropped 15 bps to 4.13% (up 39bps). Italian 10-year yields fell 13 bps to 2.22% (up 41bps). Spain's 10-year yields sank 19 bps to 1.69% (up 31bps). German bund yields slipped three bps to 0.40% (up 20bps). French yields dropped 12 bps to 0.99% (up 31bps). The French to German 10-year bond spread narrowed nine to 59 bps. U.K. 10-year gilt yields declined five bps to 1.20% (down 4bps). U.K.'s FTSE equities index fell 1.2% (up 2.7%).

Japan's Nikkei 225 equities index declined 1.3% (up 0.8% y-t-d). Japanese 10-year "JGB" yields slipped a basis point to 0.065% (up 3bps). The German DAX equities index dipped 0.3% (up 5.1%). Spain's IBEX 35 equities index added 0.6% (up 10.2%). Italy's FTSE MIB index increased 0.6% (up 5.0%). EM equities were mixed. Brazil's Bovespa index declined 0.6% (up 6.0%). Mexico's Bolsa gained 1.0% (up 7.5%). South Korea's Kospi added 0.2% (up 7.0%). India’s Sensex equities index declined 0.8% (up 10.5%). China’s Shanghai Exchange rose 1.0% (up 5.3%). Turkey's Borsa Istanbul National 100 index was little changed (up 15.7%). Russia's MICEX equities index was about unchanged (down 8.6%).

Junk bond mutual funds saw inflows of $736 million (from Lipper).

Freddie Mac 30-year fixed mortgage rates fell seven bps to 4.23% (up 52bps y-o-y). Fifteen-year rates declined six bps to 3.44% (up 48bps). The five-year hybrid ARM rate slipped four bps to 3.24% (up 35bps). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed rates down 21 bps to 4.22% (up 41bps).

Federal Reserve Credit last week expanded $7.7bn to $4.436 TN. Over the past year, Fed Credit fell $14.5bn (down 0.3%). Fed Credit inflated $1.625 TN, or 58%, over the past 228 weeks. Elsewhere, Fed holdings for foreign owners of Treasury, Agency Debt rose $14.0bn last week to $3.212 TN. "Custody holdings" were down $44.4bn y-o-y, or 1.4%.

M2 (narrow) "money" supply last week surged $55.5bn to a record $13.403 TN. "Narrow money" expanded $869bn, or 6.9%, over the past year. For the week, Currency increased $3.0bn. Total Checkable Deposits jumped $70.4bn, while Savings Deposits fell $19.9bn. Small Time Deposits were little changed. Retail Money Funds gained $3.0bn.

Total money market fund assets dropped $23.3bn to $2.654 TN. Money Funds fell $98bn y-o-y (3.6%).

Total Commercial Paper added $3.6bn to $965.7bn. CP declined $124bn y-o-y, or 11.4%.

Currency Watch:

The U.S. dollar index declined 0.7% to 99.63 (down 2.7% y-t-d).  For the week on the upside, the South African rand increased 2.4%, the Mexican peso 1.7%, the Japanese yen 1.2%, the South Korean won 0.8%, the Swiss franc 0.7%, the British pound 0.6%, the euro 0.6%, the Swedish krona 0.3%, the Singapore dollar 0.2% and the New Zealand dollar 0.2%. For the week on the downside, the Australian dollar declined 1.1%, the Brazilian real 0.6%, the Canadian dollar 0.2% and the Norwegian krone 0.2%. The Chinese yuan gained 0.29% versus the dollar this week (up 0.89% y-t-d).

Commodities Watch:

The Goldman Sachs Commodities Index fell 1.3% (down 5.1% y-t-d). Spot Gold gained 1.2% to $1,243 (up 7.9%). Silver jumped 2.1% to $17.78 (up 11.2%). Crude lost 81 cents to $47.97 (down 11%). Gasoline increased 0.4% (down 4%), and Natural Gas jumped 4.3% (down 18%). Copper fell 2.2% (up 5%). Wheat dropped 2.6% (up 4%). Corn sank 3.1% (up 1%).

Trump Administration Watch:

March 24 – Bloomberg (Billy House and Steven T. Dennis): “House Republicans abandoned their efforts to repeal and partially replace Obamacare after President Donald Trump and Speaker Paul Ryan couldn’t wrangle enough votes, raising doubts about their ability to deliver on the rest of their agenda. Trump and Ryan together own the defeat of this health-care bill. Both had pledged to deliver on a seven-year GOP promise to undo the Affordable Care Act… ‘I will not sugarcoat this: This is a disappointing day for us,’ Ryan told reporters… ‘But it is not the end of the story.’ Neither Ryan nor Trump could ultimately win over rebellious party conservatives or moderates unnerved about the bill’s potential effects.”

March 19 – New York Times (Landon Thomas Jr.): “For nearly 20 years, Adam Lerrick, a conservative economist, has been a vocal scold of global organizations like the International Monetary Fund, arguing that such institutions burn through taxpayer money and foster an insular culture of elitism, bailouts and scant accountability. Now, Mr. Lerrick, a former investment banker and a visiting scholar at the right-leaning American Enterprise Institute, is set to get a chance to turn philosophy into policy, after the announcement last week that President Trump intended to nominate him as deputy under secretary of the Treasury for international finance. The selection of Mr. Lerrick, who is well known in global financial circles for his evangelical opposition to bailouts for banks, countries and investors, underscores how Mr. Trump’s economic team is turning to critics of global economic policy as it seeks to reverse decades of Washington consensus.”

March 20 – New York Times (Keith Bradsher): “A Jeep Wrangler can cost $30,000 more in China than in the United States — and the reasons illustrate a growing point of tension between the two countries. Manufactured in Toledo, Ohio, the Wrangler is a descendant of the jeeps that were used by American forces in World War II. Equipped with a 3.6-liter engine and a five-speed automatic transmission, the Rubicon edition of the Wrangler has a suggested retail price of $40,530 in the United States. But in China, the same vehicle would set a buyer back by a hefty $71,000, mostly because of taxes that Beijing charges on every car, minivan and sport utility vehicle that is made in another country and brought to China’s shores. Those taxes on imported cars have become a growing area of friction between the United States and China.”

March 19 – CNBC (Nyshka Chandran): “The White House is planning to confront Beijing over perceived injustices in its automobile industry, Axios News reported… President Donald Trump's team, including chief strategist Steve Bannon and National Trade Council director Peter Navarro, finds Chinese policy on U.S. car imports ‘unacceptable’ and are currently working on a negotiation strategy, Axios said.”

March 21 – Reuters (Amanda Becker): “An overhaul of Fannie Mae and Freddie Mac is highly unlikely to make it into this year's legislative calendar, Congressional staffers say, possibly shifting the new administration's immediate focus to allowing the mortgage financing institutions' to rebuild depleted capital… Congressional staffers say the Senate Banking Committee has begun weekly bipartisan staff briefings on Freddie and Fannie reforms, but it is starting from scratch. The House Financial Services Committee is focused on other legislation, such as renewing the flood insurance program and rolling back parts of the Dodd-Frank financial reform, pushing the mortgage giants' revamp down the to-do list, they say.”

March 19 – CNBC (Andreas Rinke): “German Defense Minister Ursula von der Leyen… rejected U.S. President Donald Trump's claim that Germany owes NATO and the United States ‘vast sums’ of money for defense. ‘There is no debt account at NATO,’ von der Leyen said…, adding that it was wrong to link the alliance's target for members to spend 2% of their economic output on defense by 2024 solely to NATO.”

China Bubble Watch:

March 22 – Wall Street Journal (Lingling Wei): “China’s central bank faces an increasingly tough balancing act, trying to contain asset bubbles and steady the yuan without triggering a cash crunch and stifling growth. The People’s Bank of China has tightened hold on credit in recent weeks, part of government efforts to rein in financial risks. The shift has pushed up short-term borrowing costs; this week the closely watched three-month interest rates at which banks lend to each other reached levels not seen in nearly two years. ‘The rising rates have made it much more expensive for small banks to borrow,’ said one trader. ‘There were people begging for liquidity.’ On Monday, some small, rural banks failed to make good on short-term funds borrowed from other lenders…”

March 21 – Bloomberg: “China’s central bank injected hundreds of billions of yuan into the financial system after some smaller lenders failed to make debt payments in the interbank market, according to people familiar with the matter. Tuesday’s injections followed missed interbank payments on Monday, the people said… The institutions that missed payments included rural commercial banks… One said a borrower failed to repay an overnight repo of less than 50 million yuan ($7.3 million). China’s smaller lenders faced tighter liquidity this week as benchmark money market rates climbed to the highest level since April 2015…”

March 21 – Bloomberg: “China’s plan to tighten rules governing the use of corporate notes as collateral for short-term loans is fueling concern that yield hunters may face losses. China Securities Depository and Clearing Corp., which oversees notes in the nation’s smaller exchange-traded market, plans to allow financial institutions to use only AAA rated company securities as collateral for short-term loans, people familiar with the matter said… The plan will make bonds rated below that level less liquid, likely driving up yield premiums, according to analysts at Guotai Junan Securities Co. and SWS Research Co.”

March 22 – Financial Times (Yuan Yang and Jennifer Hughes): “When Li Keqiang, China’s premier, told the National People’s Congress this month that the government was worried about ‘high leverage in non-financial Chinese firms’, finance directors of the country’s property developers must have winced. Balanced between their reliance on ballooning debt markets, which Beijing wants to bring under control, and a housing boom that authorities want to cool, developers have defied predictions of collapse for years… ‘China’s more heavily indebted developers are living on a knife’s edge,’ says Andrew Collier, managing director of Orient Capital Research… Real estate developers are facing a funding squeeze just as they are entering their first downturn in three years. House prices rose 40% in big cities last year but have stalled in 2017.”

March 20 – Financial Times (Gabriel Wildau): “Big Chinese cities have launched a new round of lending curbs and purchase restrictions in an effort to cool overheated property markets, as official media warn that some have veered towards a bubble. Sky-high prices in cities including Beijing, Shanghai and Shenzhen are stoking anger, even among relatively well-off professionals. Meanwhile, controlling financial risk has emerged as the dominant economic policy theme for 2017. At the conclusion of the annual session of China’s rubber-stamp parliament last week, the government pledged to ‘contain excessive home price rises in hot markets’.”

March 20 – Wall Street Journal (Ian Talley): “Investment by Chinese state-owned companies is resurgent, surpassing private investment growth as Beijing tries to fuel its slowing economy. But by backing investment by state firms, China’s government risks a financial reckoning that could injure world’s second-largest economy and is giving the Trump administration another reason to pressure Beijing on its economic policies. Investment growth by state-owned companies surged to nearly 25% last year, eclipsing the roughly 3% growth recorded by the private sector.”

Global Bubble Watch:

March 19 – Wall Street Journal (Ian Talley, Tom Fairless and Andrea Thomas): “World finance chiefs struggled during a weekend of tense talks to find common ground on boosting trade in a global economy that is finally showing faint signs of momentum. U.S. Treasury Secretary Steven Mnuchin, rejecting a concerted effort by rivals here, got finance officials to drop a disavowal of protectionism from a closely watched policy statement issued by the Group of 20… For Washington, the watered-down language that emerged in their communiqué ensures the U.S. can still use sanctions or other policy tools to punish trade partners and thwart economic policies the Trump administration believes to be unfair.”

March 20 – Bloomberg (Michael Heath): “Australia’s central bank highlighted threats in the property market and an acceleration of domestic household debt even as it lent credence to the global reflation story. ‘Data continued to suggest that there had been a build-up of risks associated with the housing market,’ the Reserve Bank of Australia said in minutes… ‘Growth in household debt had been faster than that in household income.’ The RBA’s warning comes as the economic divide in Australia sharpens with house prices more than doubling in Sydney since 2009 and Melbourne’s similarly surging as investors tap cheap money. Meanwhile in the west, the heart of an unwinding mining-investment boom, property prices are falling…”

Fixed Income Bubble Watch:

March 20 – Financial Times (Joe Rennison, Eric Platt and Nicole Bullock): “Investors are preparing for renewed turmoil in the high-flying US equity market as key measures of volatility across asset classes have eased in the wake of this month’s Federal Reserve meeting. Against the backdrop of slumbering implied volatility for equities, commodities, bonds and currencies, some investors have sought insurance against the risk of an unexpected stock market shock. That has propelled the CBOE’s Skew index, which reflects market tail risk, or the chance of a dramatic slump in the S&P 500, to its highest level since the UK voted to leave the EU in June.”

March 20 – Bloomberg (Sid Verma): “U.S. equity and debt markets have ridden a reflationary wave this year, thanks to optimism over the momentum of the U.S. economy. However, some key gauges for growth sit awkwardly with this narrative. Nominal yields on five-year Treasuries are negative when adjusted for the price outlook. And on Treasury Inflation Protected Securities five years forward, a metric the Federal Reserve uses to gauge long-term inflation expectations, the rate projected for 2022 is falling. Real rates, which have generally moved in lockstep with real gross domestic product, are some two percentage points below what’s implied by the momentum of the U.S. economy, an unsustainable divergence, according to Deutsche Bank AG. ‘We see real rates as extremely misvalued if not in a bubble,’ Deutsche Bank analysts, led by Chief Global Strategist Binky Chadha, wrote…”

March 20 – Bloomberg (Chris Bryant and Andrea Felsted): “Companies have been on a borrowing binge, but you wouldn’t always know the full scale of their liabilities by looking at the balance sheet. This makes it hard for investors to compare businesses that fund their activities in different ways. Happily though, that's about to change. How come? The answer is buried in the notes to financial statements... It’s here that companies have parked about $3 trillion in operating lease obligations… For non-financial companies, those obligations equate to more than one quarter of their long-term (on-balance sheet) debt. Operating leases are actually pretty similar to debt. They represent money companies will be obliged to cough up in future to rent things like planes, ships and retail floor space.”

Brexit Watch:

March 21 – Reuters (William James, Elizabeth Piper and Gabriela Baczynska): “Prime Minister Theresa May will trigger Britain’s divorce proceedings with the European Union on March 29, launching two years of negotiations that will reshape the future of the country and Europe. May's government said her permanent envoy to the EU had informed European Council President Donald Tusk of the date when Britain intends to invoke Article 50 of its Lisbon Treaty - the mechanism for starting its exit after a referendum last June in which Britons voted by a 52-48% margin to leave the bloc.”

Europe Watch:

March 20 – Reuters (Andreas Framke): “Money created by the European Central Bank to shore up euro zone growth and inflation is piling up in Germany as investors are reluctant to venture outside the bloc's strongest economy, Bundesbank data showed… A large amount of the money printed by the ECB to buy bonds is landing in German bank accounts, often held by foreign investors, and staying there. This is pushing up the Bundesbank's net credit with the ECB's Target 2 system for settling cross-border payments in the euro zone, which rose to a record high of 814 billion euros in February. In the same month, Italy's Target 2 liabilities hit an all-time high of 386.1 billion euros, which the Bank of Italy blamed on factors including Italians investing their savings abroad and the ECB's bond purchases.”

March 20 – Bloomberg (Alessandro Speciale): “European Central Bank Governing Council member Ignazio Visco said the central bank could step away from its commitment to keep interest rates low for a long time after quantitative easing stops. While the ECB’s current guidance foresees that borrowing costs will stay at current or lower levels ‘for an extended period’ and won’t rise until ‘well past’ the end of bond-buying, the Bank of Italy governor said this period ‘could’ be shortened.”

March 21 – Reuters (Crispian Balmer): “Italy's anti-establishment 5-Star Movement, benefiting from a split in the ruling Democratic Party (PD) and divisions in the center-right, has built a strong lead over its rivals, an opinion poll showed… The Ipsos poll… put the 5-Star, which wants a referendum on Italy's membership of the euro, on 32.3% - its highest ever reading and 5.5 points ahead of the PD, which was on 26.8%. The survey suggests that the 5-Star is likely to emerge as the largest group in national elections due by early 2018…”

Federal Reserve Watch:

March 19 – CNBC (Javier E. David): “It’s often said that good things come to those who wait — but a bloated $4.5 trillion balance sheet might be a notable exception to that rule. With the Federal Reserve facing a Herculean conundrum in unwinding its crisis-era monetary policy — and a likely leadership transition on the horizon — Goldman Sachs suggested on Saturday the central bank could move early to reduce the vast sums of government and mortgage-backed securities (MBS) it holds on its books. In a research note to clients, the bank pointed to the likelihood that President Donald Trump may ‘reshape the leadership’ of the Federal Open Market Committee (FOMC)… as the terms of Fed Chair Janet Yellen and Vice Chair Stanley Fischer expire in early 2018. ‘This could be important for balance sheet policy because many Republican-leaning economists have criticized quantitative easing (QE) and have expressed a preference for rapid balance sheet rundown, perhaps even through asset sales,’ wrote Daan Struyven, a Goldman economist.”

March 20 – Bloomberg (Liz McCormick, Matt Scully, and Edward Bolingbroke): “As far as bond buyers go, the Federal Reserve is pretty laid-back. Even as the central bank amassed trillions of dollars of debt to prop up the economy following the financial crisis, it didn’t hedge its holdings or worry about gains and losses that might keep ordinary investors up at night. This extreme buy-and-hold stance has had an incredible calming effect on the bond market. Volatility has plummeted to lows rarely seen in recent memory. But all that is now poised to change. With interest rates on the rise, analysts say the Fed could start shrinking its unprecedented $1.75 trillion position in mortgage-backed securities by year-end. That’s likely to leave more in the hands in private investors and result in increased hedging activity, a practice that has historically exacerbated swings in the Treasury market.”

March 21 – Reuters (Jonathan Spicer): “The run-up in U.S. real estate prices could potentially amplify any future economic downturn, a Federal Reserve official said…, urging regulators globally to consider tools beyond interest rates that could help cool the sector. A sharp downturn in U.S. residential and commercial property prices in 2007 and 2008 rocked banks that were highly leveraged in the sector, sparking the global financial crisis and deep recession. With the economic recovery now well under way, bank holdings of commercial and apartment mortgages rose 9% and 12%, respectively, in the past year. Eric Rosengren, president of the Boston Fed and an influential financial regulator at the U.S. central bank, said the ‘sharp’ rise in apartment prices in particular may signal financial instabilities that interest rates, which are only gradually rising, may not be able to contain.”

March 21 – Bloomberg (Oliver Renick): “Federal Reserve Bank of Cleveland President Loretta Mester called for the U.S. central bank to continue with gradual interest-rate increases and begin shrinking its $4.5 trillion balance sheet this year if the economy continues to improve. ‘If economic conditions evolve as I anticipate, I would be comfortable changing our reinvestment policy this year,’ Mester said… ‘Ending reinvestments is a first step toward reducing the size of the balance sheet and returning its composition to primarily Treasury securities over time.”

U.S. Bubble Watch:

March 21 – Reuters (Lucia Mutikani): “The U.S. current account deficit unexpectedly fell in the fourth quarter, hitting its lowest level in more than a year, as an increase in the primary income surplus offset a soybean-driven drop in exports. The Commerce Department said… the current account deficit, which measures the flow of goods, services and investments into and out of the country, fell 3.1% to $112.4 billion, the lowest since the second quarter of 2015… The fourth-quarter current account deficit represented 2.4% of gross domestic product… For all of 2016 the current account deficit totaled $481.2 billion, a 3.9% increase from 2015. That represented 2.6% of GDP, unchanged from 2015.”

March 21 – Wall Street Journal (Anjani Trivedi): “The U.S. car-financing market is flashing worrying signals. And the big Japanese car makers will take the first hits. Car-lease volumes in the U.S. have risen rapidly over the past two years for Japan’s big three car makers. Toyota Motor, Honda Motor and Nissan Motor have been among the most aggressive this cycle, with close to 30% of sales coming from lease transactions for all three, according to Jefferies. For Ford Credit, for instance, the rate is rising but still at 22%. The problem so far isn’t with customers defaulting on leases but with the recovery value the finance companies get when they sell the vehicles after the lease term.”

March 19 – Financial Times (Adam Samson and Nicole Bullock): “The US corporate profit outlook has dimmed in recent weeks, with analysts paring back their forecasts, in a fresh sign of the risks facing the Wall Street rally that has powered equities to record peaks. Earnings for companies listed on the S&P 500 index, the main US stock barometer, are predicted to rise 9% in the first quarter, FactSet data show. While the rate marks a significant uptick from the 4.9% notched in the final three months of 2016, it represents a reduction from the 12.3% expected at the start of this year. The weaker estimates come at a time when stocks are trading near record highs.”

March 18 – Financial Times (Chris Flood): “Exchange traded funds have attracted the biggest inflow of money in the first two months of the year on record, heightening concerns that ETF buying is fuelling an unsustainable price bubble in the US stock market. Investors across the world ploughed $131bn into these index-tracking funds in the first two months of 2017, according to ETFGI… This follows a record-breaking year in 2016, when ETF managers gathered more than $390bn in new cash.”

March 20 – Bloomberg (Dani Burger): “They call them smart-beta funds, but there are plenty of critics who say they’re anything but smart. What they certainly are is popular: investors have poured more than $430 billion into them over the past decade. The hope is that they deliver the kinds of market-beating returns that pricey hedge funds have long dangled before rich investors, but at index-fund fee levels. The fear is that it’s become yet another way for investors to buy into a bubble.”

March 20 – Wall Street Journal (Theo Francis and Joann S. Lublin): “Pay raises are back in style in the corner office, wiping out cuts from a year earlier and pushing CEO compensation to new highs amid a surging stock market. Median pay for the chief executives of 104 of the biggest American companies rose 6.8% for fiscal 2016 to $11.5 million, on track to set a postrecession record, according to a Wall Street Journal analysis.”

March 21 – Reuters (Ankit Ajmera and Nathan Layne): “Sears Holdings Corp, once the largest U.S. retailer, warned… about its ability to continue as a going concern after years of losses and declining sales. ‘Our historical operating results indicate substantial doubt exists related to the company's ability to continue as a going concern,’ Sears said… The company said an inability to generate additional liquidity might limit its access to new merchandise or its ability to procure services. Continued operating losses also could restrict access to new funds under its domestic credit agreement, according to the filing.”

March 23 – Bloomberg (Gabrielle Coppola and Matt Scully): “Since the auto industry’s near-death experience, sales have come roaring back -- last year, a record 17.55 million vehicles moved off U.S. dealer lots. A secret ingredient? Consumer debt, and plenty of it. But things are starting to look a little trickier, as passenger car sales are dropping, overall vehicle sales have plateaued and the Federal Reserve has started to raise borrowing costs. Add to that rising default rates and faster depreciation of used car values, and there’s new anxiety simmering over the state of the U.S. auto finance market. Is there an auto loan bubble?”

March 23 – Reuters (Nandita Bose and Richa Naidu): “Suppliers to Sears… told Reuters they are doubling down on defensive measures, such as reducing shipments and asking for better payment terms, to protect against the risk of nonpayment as the company warned about its finances. The company's disclosure turned the focus to its vendors as tension is expected to mount ahead of the key fourth-quarter selling season amid rising concern about a potential bankruptcy, they said. The storied American retailer, whose roots date back to 1886, said on Tuesday that ‘substantial doubt exists related to the company's ability to continue as a going concern.’”

Japan Watch:

March 21 – Bloomberg (Connor Cislo): “Japan’s exports rose for a third consecutive month in February as strengthening global demand continued to help the nation’s moderate economic recovery. The increase was the biggest in two years, reflecting the timing of Lunar New Year holidays in Asia. Exports rose 11.3% from a year earlier (median estimate 10.1%)…”

Leveraged Speculation Watch:

March 21 – Wall Street Journal (Alexander Osipovich): “The flash boys aren’t as flashy as they used to be. High-speed trading gained notoriety after Michael Lewis’s 2014 book ‘Flash Boys.’ These days, the industry is struggling with another problem: It is having trouble making money. HFT firms use computers to buy and sell stocks, bonds or other financial assets in fractions of a second. The once-lucrative business is now fighting unfavorable market conditions, brutal competition and rising costs. Revenues at HFT firms from U.S. equities trading were an estimated $1.1 billion last year, down from $7.2 billion in 2009…”

Geopolitical Watch:

March 20 – Reuters (Kevin Yao): “China's government has been seeking advice from its think-tanks and policy advisers on how to counter potential trade penalties from U.S. President Donald Trump, getting ready for the worst… The policy advisers believe the Trump administration is most likely to impose higher tariffs on targeted sectors where China has a big surplus with the United States, such as steel and furniture, or on state-owned firms. China could respond with actions such as finding alternative suppliers of agriculture products or machinery and manufactured goods, while cutting its exports of consumer staples such as mobile phones or laptops, they said.”

Friday Afternoon Links

[Bloomberg] GOP Cancels Health-Care Vote as House GOP Balks at Bill

[Bloomberg] Stocks Fall, Bonds Rise as Health Vote Pulled: Markets Wrap

[Bloomberg] Dollar Drops to Fresh Low on Uncertainty About Health-Care Vote

[Bloomberg] Oil Drops for Week on U.S. Supplies Before OPEC, Allies Meet